This paper attempts to extend on the work by Cassou and Hamilton(2000) and Smulders and Gradus(1993) on the links between the environment and economic growth, particularly the optimal environmental policy and the policy effects on growth rates and welfare. Using a simplified version of the endogenous growth model with linear production, the paper examines how environmental policy promotes economic growth in the presence of externality. Environmental taxation and to a lesser extent,technical standard, are examined and compared in terms of their long-run effects on growth. This paper diverges from previous analyses by looking at environmental quality as flow variable that is influenced by regular capital and abatement capital. The paper considers a case where environmental quality enters the consumption and production functions, something not applied in most of the literature. For tractable solutions, a simple AK endogenous growth model is used in the analysis in addition to the general specifications of production technology and preferences. The AK model shows constant returns to broad capital. When environmental quality is incorporated, the model shows increasing returns to scale.

The paper considers only steady-state analysis and some discussion of transitional dynamics. The paper concludes that environmental quality curtails or promotes economic growth depending on its evolution over time. Appropriate choices of environmental policy instruments enable the competitive equilibrium growth to be Pareto optimal, hence improving the social welfare. In steady states, the technical standards are constant or independent of the level of economic variables, but the effluent tax is increasing at a rate proportional to the steady-state growth rate of the economy. In addition, the price level in capital market determines both the optimal technical standard and optimal tax rate.

Though the interactions between economy and the environment appear to be complex, it would be interesting to examine them by addressing such questions as the relations between the environmental quality and long-run growth, and how the environmental policy affects the growth rates. Research that endeavors to shed light on these issues will not only be of educational value but also help policy makers grasp the intricacies of national development that is concomitant with improved environmental quality.

Section 2 presents the basic model of endogenous growth with the environmental sector, and then the AK model is used to compare the decentralized competitive equilibrium and social optimal paths in the presence of environmental quality. Section 5 examines the optimal environmental tax on growth and then the conclusion follows with the paper and puts forward the needs of further research that may be of significance.